To Leverage or Not to Leverage – This is the Question…

There is always a lot of discussion within the real estate circles on the subject of high leverage; specifically the issue of how high is too high. Let me come right out and tell you that I am biased in this matter – I specialize in creative finance and one of my objectives in each and every acquisition is to arrive as close to 100% financing as possible. Every technique and every negotiable term within my world of creative finance and acquisition exists for one of two reasons – either to make the deal more profitable, or two make it possible, or doable, in the first place. Leverage can do both! So, let’s talk leverage…

Do You Have Cash?

Real estate investing, as it relates to acquisition of long-term income-producing property, is a cash-intensive game. Do you have cash? If you needed to hand over a check representing 25% of the purchase price on a $160,000 building to an institutional lender, would you be able to it?

I can tell you that when I started I could not, and in this way I was likely no different from most people reading this article. The consequence of not having a lot of money is that we either have to utilize higher levels of leverage in order to enter the game, or we must simply accept defeat before we even start. Since defeat is not an option, we are left with leverage.

I don’t know how much more plainly I can put this for all of the naysayers who oppose leverage in all of its incarnations. If you inherited money or are fortunate to be in high-paid professions which facilitate making fat down-payments on your real estate acquisitions – good for you. But, for those of us who are less fortunate, creative utilization of higher levels leverage is an absolute requisite –period!

What about the Returns?

But aside for allowing us into the game, leverage also makes our deals much more profitable as it relates to Cash on Cash return. Let us consider a hypothetical purchase of a 4-plex for $160,000, where the Gross Income is $2,400/month (600×4) and the Operating Costs are $1,000/month, leaving us with the NOI of $1,400/month. Let us evaluate the Cash on Cash return in this deal based on three financing options: 25% down, 10% down, and 100% financing.

Recognizing that the exact terms of the underlying financing will play a HUGE role in this, a subject that will have to be covered in future articles, for the scope of this discussion let us assume that the financed portion in all of the examples will be represented with a 30-year amortized note at 6%. Also, let’s assume that the closing costs in each of the examples are wrapped into the financing. And finally, let’s say that all of the units are rented on the day of closing and that there are no immediate delayed maintenance issues. Below is a rudimentary analysis of the cash flows in each of our examples:

A quick consideration of the above will bring to light several interesting realities:

Cashflow In the above example, going from a $40,000 down-payment to a $16,000 down-payment resulted in a relatively modest loss of cash flow of about $144/month – we went from $680/month to $536/month.Question: Presuming that the underlying financials are strong enough to support doing so, would you be willing to give up $144/month of cash flow in order to keep $24,000 of your money in your pocket?
Framed differently;

If you simply do not have $40,000 but you do have $16,000, would you be willing to spend an extra $144/month on your cost of money if doing so enables you to buy this building whereas otherwise you could not? For me personally, the answers are always YES and YES – you make your own decisions…

Infinite Returns I indicated that 100% financing in our third example resulted in INFINITY Cash on Cash return.

Question: How else would you quantify earning $440/month of cash flow having invested $0 of your own capital?

Insufficient Funds Most people would agree that the greatest obstacle to acquisition of income-producing real estate is insufficient funds for down-payments.

Question: Would you agree that 100% financing effectively bypasses the need for down-payments and therefore, at least in theory, it can enable you to down an unlimited number of deals?

Leverage with Cashflow Last but certainly not least, please note that even at 100% financing, the property in this example is still showing more than $100/month per door of cash flow! Granted – not just any old 4-plex out of your local MLS will be able to do this for you. Leveraged deals force us to be very picky about what we buy indeed. An OK deal is simply not going to yield enough to allow for healthy cash flow when fully leveraged. We are forced to do only above average deals!

Hopefully, this gives you a birds-eye view of the benefits of leverage and ways in which leverage has the potential to impact out business in a very positive way.

It’s not all this simple:

For all of my apparent “love affair” with leverage, I am the first to admit that you must be smart and very well educated before attempting to utilize higher levels of leverage. Do not over-leverage the equity under any circumstances, though this may be tempting from time to time. Property values can and do cycle down with regularity and you need to be careful to ensure that all of the lenders are adequately collateralized. Leave yourself a margin for error. And most importantly, you must make sure that your Net Operating Income easily covers all of the debt service and leaves you with plenty of cash flow! The latter will allow you to weather the storms that inevitably will come your way!

By definition, leverage is one of the great advantages of real estate as an investment vehicle, and utilized correctly leverage tees-up great possibilities for a sophisticated investor!

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About Author

Ben Leybovich has been investing in multifamily residential real estate since 2006. His area of expertise is creative finance. Ben works extensively with private as well as institutional financing. Ben is a licensed Realtor with YOCUM Realty in Lima, Ohio. He is also the author of Cash Flow Freedom University and creator of a cash flow analysis software CFFU Cash Flow Analyzer.

49 Comments

I’m looking forward to your follow-up post, wherein you explain, step by step, how to get a 0% down real estate loan! I have been sitting out the market low because I simply don’t have the money for a down payment on investment property. I would love to have other options.

You will never get a 100% institutional loan – period. It is not reasonable for institutional lenders to do this. What we are talking about here is creative finance. A combination of private, hard, institutional, bridge, refinance, substitution of security, negative amortization, blanket – you name it, I’ve done it. Well almost; never did hard money.

Thanks Ben! I knew that no institutional lender would do 100%, and I’ve considered some of the other paths you mentioned. Over the last year, I have been reading advice on BP and elsewhere, planning my investment business. In that time, my wife and I bought our home, and I’m hoping to be able to use the equity in the future as a down payment- is that what you mean by substitution of security?

I’m not familiar with negative amortization and blanket… looking forward to reading your future posts on these subjects!

Using the available equity can be a viable option. This is not what I mean by substitution of security. SOS is simply moving the note, or part of the note, off of one piece of real estate (security) onto another. This is not something you are likely to do with any conventional note. But, in the world of non-institutional lending this is possible. This is more “high-flying” creative finance stuff. If you are just starting out, I would not advise you go there. $$ followes knowledge…:)

I did it with a local credit union. The credit union financed 70%, the owner carried the remaining 30%… between the 2, 100% financing. I actually walked out of a few closings with cash as I had included closing costs in my financing and they owed me for taxes.

It allowed me to pick up 8 properties in 1 year, somewhere in the neighbor hood of $700k in financing (note to self, add them up)… all with initial cash of about $30k from a liquidated 401(k).

It is possible… you just have to do the legwork to find the lenders and the sellers that’ll let you do it.

A great post for the risk-takers out there, of which I am one. By leverage, are you referring to pulling equity out of a property and hard money loans? I realize you can’t cover all the details in one post, but sharing a case study or two of ways you’ve been creative in using leverage would be great. Thanks for the upbeat article.

Your comment caught my attention because of ward “risk”. The way I see it, the practice of down-payment requirement is required by institutional lenders because they see you, the investor, having skin in the game as a safety trigger for them – the bank. Down-payment has nothing to do with safety on your end as the investor.

What constitutes safety for us is cash flow. In fact, I strongly believe that a good deal should show strong cash flow even when fully financed; anything less and you are just “buying” safety and cash flow with your down-payment. This, in my opinion, is the wrong way to invest!

Most of my deals include a blend of private and institutional money, but in the 7 years of doing this, I’ve never used hard money. Below is a thread in which I discussed my latest acquisition. It includes a few numbers if you are interested. I may do some additional deal analysis in the upcoming articles. Thank you so much for reading and commenting.

Agree with James’ comment. How do you get money for needed 20-25% down? I had to come up with 20% down for primary residence multifamily, and 25% down for next purchase I am on contract to purchase which is multifamily investment loan. How can I save my cash on this purchase? ..Hard money lenders don’t apply since they want to see your money up front also.. Find a friend to loan you money? why would they loan me money without me showing any skin in the game? If refinancing is the answer, how do I refinance within first year of purchase if not enough equity is available?

Thanks for your comment. Would you believe it if I told you that right this minute, if a deal came across my desk that was so good that I’d want to be involved in it, I would simply pick up the phone and tell a few people about it. I may get the money, or I may not. Likely I would because by now people know that if I am interested, it is likely a really good deal.

This doesn’t happen over night. But the reality is simple:

Nobody takes action in the world of real estate unless it is to solve a problem. Believe me when I tell you that the money has a problem to solve. May be it is higher rate of return; may be the problem is diversification; may it is safety. The point is that as an entrepreneur your job is to cater a solution.

We buy to solve our problems. We buy to solve the seller’s problems. We buy to solve the money’s problems. Exactly how we structure our deals is a function of what problems we are solving.

If you can’t pick-up your phone and get multiple people on the other end who are in position to finance a really good deal, you are not hanging with the right crowd 

It’s not simple, and it certainly is not quick. Real estate is not about dirt – it is about people!

Sometimes, the “down payment” can be the good deal you find. So, if you have a property worth $100k, and using smart buying techniques, you can get it for $70,000 – then it’s kinda like paying $30,000 down. Obviously a traditional lender wouldn’t look at it this way, but using creativity, you can make this happen. This is why I love this game!

Brandon,
Not to mention that a solid real estate deal must have expandability opportunities built into it whereby we can force appreciation quickly – this is a subject for one of my upcoming articles. Thanks for commenting Brandon.

A sensible way of using leverage is having a back up or slush fund that could be used to bail yourself out if things go wrong. High leverage if you are cash poor is a big gamble. If you have other assets that could be liquidated, you can have the best of both Worlds… Each situation is different though.

Leverage is not the main problem in my opinion. Our ability to service the debt associated with that leverage is much more of the essence, and this is a function of the property you’ve bought and the terms.

I would shy away from short-term high leverage. In investing, principal #1 is safety, which is a function of time first and foremost. Unless you have to sell, equity does not matter. And fortunately, cash flow does not travel in tandem with equity.

I don’t really understand the notion of paying cash for investment property. We can disagree as to the appropriate level of financing, but leverage is one of the inherent advantages of real estate as an investment vehicle as compared to everything else out there.

Allow me to point something out. When we think about value in RE, most people automatically assume dirt and the structure on top of it. While it is true that there is value in bricks and dirt, what people often forget, or simply do not know, is that negotiable terms, financing being one of many, can hold just as much if not more value than the building.

What this means is that while most people out there are searching for buildings, I search for terms…This is a very different view, perhaps a more sophisticated view of real estate indeed. I do not do many deals – may be 1 per year. But the deals that I get involved in are not of the sort that you will find on the MLS and finance traditionally with a salable note…

Hey Bill, I totally disagree! There are so many properties out there, you just have to know where to look. If you look on the MLS, you will definitely *not* find deals. But if you find the insider routes and connections, you will get bombarded with good deals. Of course it depends on the types of deals you are most interested in as far as where to look, but they are there.

Now 100% financing, I’d agree if you said that was hard to find these days!

The main problem the article doesn’t touch on, is how ROI can be affected by too much leverage. If you could get 100% financing and get $440 cashflow a month, but the value of the asset drops (because of economic or other variables) to 90% all of a sudden you owe $160,000 on a property that is worth $144,000. If someone in this case is cash-strapped and some emergency (litigation, illness) requires them to liquidate they would have to do so at a loss. This is why individuals shouldn’t over leverage.

I couldn’t agree more. I should have made this point clear, and I will do so in one of the upcoming articles.

100% leverage and 100% financing are not at all the same thing. If we are buying a building for $160,000 which is reasonably worth $180,000 as it sits, plus there are ways to improve the intrinsic value by improving the NOI through rent hikes or restructuring of expenses to say $195,000, then financing 100% of the purchase price is not the same thing as leveraging 100% of the value. This doesn’t work as well with small multiplex as it does with larger structures, but in principal would you agree? I used an example of a 4-plex because it is easier for most people to associate with. I’ll be discussing this in one of the upcoming articles.

Not sure I agree Patrick. I see your point for sure, and that is a risk, but what are the odds you’d HAVE to get rid of a property? Litigation shouldn’t be an issue if you have the right insurance coverage (umbrella policy) and if it were illness, there would always be seller-financing options you could do.

I think over leveraging only matters depending on what you do with the money.

A new investor who is cash strapped to begin with, could have hundreds of different reasons why they need to cash out. The point is teaching people that leverage for the sake leverage is always a good move, is really bad information. No matter which way you cut it too much leverage can amplify your losses, in a downturn or some other unforeseen event.

I couldn’t agree more Patrick. Doing anything for the sake of doing it is never a good thing. But, we don’t leverage for the sake of leverage. We do it because it unlocks equity which we can then trade for cash flow! Some people are happy seing more zeros on the balance sheet. To me, that is useless. I need cash flow to live and invest another day.

I do not suggest over-leveraging. Be reasonable. Having said that, leverage is a powerful tool. Thank you for your thoughts

To add to what Ali says, the more equity you own, the more attractive you look to a potential law suit Patrick. If you study big money, and I have, you will note that assets are most always leveraged to the max, as long as the cash flow covers the cost of carrying. The money is then used to acquire more assets, and the process repeats. There is always a lot of cash flow, but usually not a lot of equity. We live in a litigious world, and this is the best LEGAL method of draining equity.

Pat, I disagree completely… One of the beauties of leverage is you’re betting the banks money.

It may depend on your ethics and your thoughts on strategic default, but the more leveraged you are, the less risk you’ve taken on.

Lets say you but a $200k house with 100% financing. In a good world, it appreciates 10%. You just gained $20k without risking any cash. Lets say it drops $20k. You’ve lost $0. You could walk away and your only hit is your credit score.

Now lets say you put 25% down. In case one, you risked $50k of your cash to make $20k… not a bad return. Of course in the other case, your $50k is now worth $30k but the bank still has full power (a foreclosure still costs you $30k of your investment).

The more leverage you have, the more power you have. The more money you put into a property, the more power the bank has. You lose the ability to strategically default.

“It may depend on your ethics and your thoughts on strategic default, but the more leveraged you are, the less risk you’ve taken on”

You know, my dad may have been too conservative, but he would never walk away from a debt.
He paid off his commercial properties as soon as he could. He lived modestly and re-invested most of his money.
Many people in the last decade lost everything when the real estate market tanked and they were over-leveraged. When my dad passed, he had a portfolio worth about $4,000,000.
My brother and I are trying to follow in his footsteps. We may also be too conservative but we would not walk away from a debt.

For the non-financial guys out there, you should know that the difference between the $40,000 and $16,000 downpayment is equivalent to borrowing that money at 25% for 30 years. If you don’t have the ability to stroke the $40k check, then that’s a great solution. If you can stroke the $40k, you might want to consider the effective cost of borrowing that money!

I do like the post and am constantly flabbergasted by investors who refuse to use leverage in order to juice their returns. All leverage isn’t bad!

1st, I’m not enamored with the idea of a 30 year mortgage on an investment property, but that’s just me. My big problem with this analysis is the assumption that you’re going to end up with the same interest rate (6%) whether you bring in 25, 10, or 0% down. It doesn’t work that way in my world. 25% down get’s you a lower rate and 0 down a much higher rate. It makes all the difference.

You are correct. The terms of borrowing have a lot to do with the viability of leverage in a particular investment. The example was a very simplistic example indeed. However, this is why I mention that you must look at extraordinary deals, not just OK deals, if higher levels of leverage are involved.

Here is my bottom line: If you put money down in order to either limit your principal balance or lower your interest rate because this is the only way to achieve healthy cash flow, then the deal is not good enough to begin with. A fat deal must be able to cash flow well at 100% leverage. Then, if you feel safer by making a down-payment then do by all means. But, a deal must work well with 100% leverage, or else I don’t play!

I had a situation to borrow up to 110%, called CTL loan, go google it!!!!
It was a Walgreens at 7.35% cap rate, and ingterest I settled was 6.11%, 24 yrs fix, to match lease term, but put down 18% to get COC of 4,50%. Borrowing 100 % or more will gove negative cash flow of 3-4 k per month. Needed income as a retiree. What U would have done 3yrs a go, deal was done. thanks
kris

I think that you may misunderstand my premise. I buy buildings because they represent passive revenue streams – this is non-negotiable. Financing, healthy cash flow takes precedence over financing. What good is financing, if there is no income?

My experience tells me that all things being equal, a minimum of 10 CAP is required to accomplish 100% financing and still maintain healthy levels of CF. 11-12 CAP is better.

So, the answer to your question as to what I would have done – I would never have given it another look unless the price was cut by at least 30%. The deal was simply not good enough. Putting money down in order to lower the principal balance to open-up cash flow is precisely the wrong thing to do! 4.5% cash on cash number simply doesn’t exist in my universe of possibilities Kris.

Thanks Ben,
In my case, needed no toilets, but NNN deal. Sold CVS, loan was coming due in 2010, tough times to get the loan from the lender that was holding it. So to avoid any future re-finance issues again, went for 24 yrs fix rate, and at my age 71, just wanted some decent cash flow, so agreed to 4.50%, plus it was for mainly estate planning, property will be free and clear after 24 yrs. Lease may extend after that to 75 yrs, typical Walgreens deal, sad news is rent stays same!!!!
Nothing else made sense for NNN deal.Thanks
kris

This turned out to be a candid and pertinent exchange – thank you. I personally stay away from commercial stuff. First, it is more difficult to finance. But more importantly, I prefer to deal with basic necessities, which relative to real estate is residential zoning.

What you have can either be really good, if you are lucky to have a 5-star NNN tenant, or it can eat you alive if they don’t resign as these buildings can take years to fill…I am sure you’ve taken this into consideration.

Your age is a factor, I appreciate this indeed. You needed “hands-off” cash flow, and this was your answer. My answer is different. I am building systems which will allow me, once the company is large enough, to pass the day to day management over to employees whom I personally will train. Furthermore, if my children show an interest, which if I do my job right they will, I will be able to pass the “management of the managers” to them. You paid top price for not having to do any of this work yourself, which at 71 would not have been reasonable.

This is a very interesting topic, so much so that I’ve written an article for the BP blog on this which will come out this coming Tuesday. I find it intriguing that our exchange pre-empted my article by only a few days. But yes, I understand what you are about with this deal. Good luck to you and I hope they stay forever.

Ah, well explained, thanks for a clear and concise post & introduction to the wonderful charms of leveraging and finance. The devil’s in the details, though, isn’t it – “…Do not over-leverage… Property values can and do cycle down with regularity and you need to be careful to ensure that all of the lenders are adequately collateralized…make sure that your Net Operating Income easily covers all of the debt service and leaves you with plenty of cash flow…”

Those short few paragraphs there could (and do) fill up a few dozen very thick books…and also a fair few bankruptcy and litigation queues…;)

Thank you for your comment. The point that I did not make clear enough in this article, and I should have, is that in referring to 100% leverage I am talking about leveraging the purchase price, not so much the equity. In other words, if I am paying 200 for the building which is worth 240k, but within a few months due to strategic management utilizing principals of expandability this building will be worth 275k, then in leveraging 100% of purchase price I still end up in a safe debt to value position. Furthermore, I may even decided to pull another 20 or 30k out that via a blanket cross collateral loan. All of this is contingent on strong CF of course.

We have to do it right, and it is contingent on an individual investor’s comfort and fluency, but would you agree that in principal leverage is the single greatest advantage of RE as an investment class as compared to everything else out there?

I have virtually zero practical knowledge about any other types of investment, so it’d be hard for me to say – I would probably agree that principal leverage is one of the best available investor tools, that doesn’t exist in other areas of investment, when used wisely – and also one of the most dangerous when used unwisely. It’d be good if all finance advisors would have been (as I’m sure you are) responsible and professional consultants, with only their clients’ interests and long-term serviceability in mind – unfortunately, as the last decade has shown us, this is not always (not to put too fine a point on the actual percentages) the case.

I agree – leverage is a sword that cuts both ways! I feel compelled to add that I am not really advising anybody so much as I am telling my story. What story? A story of a classically trained violinist who has been diagnosed with Multiple Sclerosis – an autoimmune disease which will over time severely impact my physiology, who became a student of creative finance and acquisition of real property.

I own 28 units in Lima, Ohio, the first 18 of which were financed at 100%. The 10-plex that I closed on February 4th, 2013 required me to bring $5,200 to closing – this was a first for me…

My portfolio cash flows about 45k annually, and so long as I can make the debt service payments, I really don’t care what happens to the equity. Everything I buy, I hold long-term, and I am very happy to wait for 20 years while the market rewords me with additional value, which I can then leverage to acquire additional cash flow!

When people ask me how a violinist (on a musician’s income) can do all that I’ve done, I answer – leverage. This is my perspective which is a result of my experiences. My point is simple – I could not have done this with stocks, bonds, metals, crops, pork bellies, or any other asset class or vehicle, because only in RE do we benefit from leverage in the way that we do…

I had a doctor friend in ohio, and in 1980’s, he believed in single family homes, and I liked apt bldg’s. But both were happy and successful in our investments. I liked manager for my operation, where as he managed himself. I was lucky to make $ when I bought 12 units for 250k, it was worth 400k!!!! Seller was trying to sell 12 condo units at 35k each, but by selling all as a package he saved taxes, and we negotiated to the satisfaction of both. Bad part was assessor gave hard time to me for 10 yrs!!!! Thanks
kris

Real estate is the greatest form of capital leveraging around for the average investor. While their are other forms of “investing”, i.e. currency and commidty markets, that offer far greater leverage ratios than real estate investing does. I have to partially disagree with your assessment that high leverage will leave one with the best COC return. Personally I find that 100% cash purchases leave one with better COC returns. How? By purchasing for 100% cash one can close quickly, and often at 30 to 45% discounts over listed prices. Then it is easy to go to the bank and get a refi for the original value with a 25% down payment built in with a 5% equity cash out and higher monthly cash flows than a 100% financing of the listing price.

Thank you much for your comment. Let me say that I completely agree with your method – this is an excellent way to get into 100% financed property and I utilize it myself. However, if I can point out that what you end-up with is precisely 100% financed property – no money down. This is one of the techniques we use to accomplish the stated goal of no money down indeed. Good for you for figuring this out! Having said this, you’ll find that the banks will get weary of this after so many deals…You will also find that unless you specufucally focus strictly on bank-owned SFR, it becomes difficult to get 60 cents on the dollar on quality deals, which makes this method ineffective. Thoughts?

Yours is a good comment and as such I will acknowledge it. You should know, however, that if you have an expectation of me taking my time to address you, then you should at the very least sign your name to your opinion. We are all friends here and we all want the same thing – to speak our minds and be afforded due respect. By not using your name you are showing disrespect to this community; a community which is greater than any one of us individually. Please consider adding a picture and your real name

Now – you are right in that leverage should always be coupled to good-quality assets; assets that have propensity for retaining and improving value. You are also right that an above-ordinary deal is requisite. Finally, you are right that these deals are not commonly found in the MLS. I don’t look for deals – they come to me. There aren’t very many, but I don’t need many; as long as the ones I do are excellent.